============================================================================== UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) /X/ QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 1998 OR / / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 Commission file number: 0-19231 REDWOOD EMPIRE BANCORP (Exact name of Registrant as specified in its charter) California 68-0166366 (State or other jurisdiction of (IRS Employer Incorporated or organization) Identification No.) 111 Santa Rosa Avenue, Santa Rosa, California 95404-4905 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (707) 573-4800 Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 During the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No --- --- Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. August 5, 1998: 3,364,181 ============================================================================== This page is page 1 of 24 pages. REDWOOD EMPIRE BANCORP AND SUBSIDIARIES INDEX Page ---- PART I. Financial Information ITEM 1. Financial Statements Consolidated Statements of Operations Three and Six Months ended June 30, 1998 and 1997 .......... 3 Consolidated Balance Sheets June 30, 1998 and December 31, 1997 ........................ 4 Consolidated Statements of Cash Flows Six Months Ended June 30, 1998 and 1997 .................... 5 Notes to Consolidated Financial Statements ................. 7 ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operations ........... 10 PART II. Other Information ITEM 2. Changes in Securities ...................................... 22 ITEM 4. Submission of Matters to a Vote of Security Holders ........ 22 ITEM 6. Exhibits and Reports on Item 8-K ........................... 23 SIGNATURES ................................................................ 24 This page is page 2 of 24 pages. PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS REDWOOD EMPIRE BANCORP AND SUBSIDIARIES Consolidated Statements of Operations (dollars in thousands except per share data) (unaudited) Three Months Ended Six Months Ended June 30, June 30, 1998 1997 1998 1997 -------------------------- -------------------------- Interest income: Interest and fees on loans $6,814 $8,396 $13,668 $17,024 Interest on investment securities 1,099 852 2,225 1,681 Interest on federal funds sold 310 237 636 515 Interest on time deposits due from financial institutions -- 3 -- 6 -------------------------- -------------------------- Total interest income 8,223 9,488 16,529 19,226 Interest expense: Interest on deposits 3,257 3,846 6,638 8,134 Interest on subordinated notes 277 276 554 554 Interest on other borrowings 75 35 149 118 -------------------------- -------------------------- Total interest expense 3,609 4,157 7,341 8,806 -------------------------- -------------------------- Net interest income 4,614 5,331 9,188 10,420 Provision for loan losses 510 585 1,020 1,170 -------------------------- -------------------------- Net interest income after loan loss provision 4,104 4,746 8,168 9,250 Other operating income: Service charges on deposit accounts 267 285 541 581 Merchant draft processing, net 605 370 1,046 792 Loan servicing income 105 199 284 515 Net realized gain on sale of investment securities available for sale -- (8) 105 (7) Gain on sale of loans and loan servicing 1,655 823 2,602 2,330 Mortgage loan brokerage revenue, net 1,230 479 2,314 812 Other income 263 187 560 321 -------------------------- -------------------------- Total other operating income 4,125 2,335 7,452 5,344 Other operating expense: Salaries and employee benefits 3,388 2,500 6,391 6,154 Occupancy and equipment expense 841 758 1,650 1,643 Other 2,079 2,296 3,916 4,270 -------------------------- -------------------------- Total other operating expense 6,308 5,554 11,957 12,067 -------------------------- -------------------------- Income before income taxes 1,921 1,527 3,663 2,527 Provision for income taxes 710 643 1,345 1,063 -------------------------- -------------------------- Net income 1,211 884 2,318 1,464 Dividends on preferred stock -- 112 112 224 -------------------------- -------------------------- Net income available for common stock shareholders $1,211 $ 772 $ 2,206 $ 1,240 -------------------------- -------------------------- -------------------------- -------------------------- Earnings per common share and common equivalent share: Basic earnings per share $ .39 $ .28 $ .74 $ .45 Weighted average shares 3,141,000 2,777,000 2,967,000 2,766,000 Diluted earnings per share $ .35 $ .26 $ .67 $ .44 Weighted average shares 3,463,000 3,364,000 3,454,000 3,352,000 This page is page 3 of 24 pages. REDWOOD EMPIRE BANCORP AND SUBSIDIARIES Consolidated Balance Sheets (dollars in thousands) (unaudited) June 30, December 31, 1998 1997 -------- ------------ Cash and due from banks $ 44,205 $ 21,505 Federal funds sold and repos 11,504 34,553 -------- ------------ Cash and cash equivalents 55,709 56,058 Interest bearing deposits due from financial institutions 6 6 Investment securities: Held to maturity (market value of $35,038 and $31,273) 34,772 30,658 Available for sale, at market 34,132 41,907 -------- ------------ Total investment securities 68,904 72,565 Mortgage loans held for sale 34,392 16,929 Loans: Residential real estate mortgage 90,699 93,516 Commercial real estate mortgage 57,507 57,425 Commercial 64,172 69,097 Real estate construction 39,625 55,031 Installment and other 6,189 9,200 Less deferred loan fees (1,915) (1,873) -------- ------------ Total portfolio loans 256,277 282,396 Less allowance for loan losses (7,930) (7,645) -------- ------------ Net loans 248,347 274,751 Premises and equipment, net 4,289 4,055 Mortgage servicing rights 463 620 Other real estate owned 5,257 6,352 Cash surrender value of life insurance 3,503 2,929 Other assets and interest receivable 10,344 12,454 -------- ------------ Total assets $431,214 $446,719 -------- ------------ -------- ------------ Deposits: Noninterest bearing demand deposits $ 97,050 $ 98,915 Interest-bearing transaction accounts 138,245 149,939 Time deposits $100,000 and over 57,703 53,878 Other time deposits 80,571 88,689 -------- ------------ Total deposits 373,569 391,421 Other borrowings 6,341 2,341 Subordinated notes 12,000 12,000 Other liabilities and interest payable 3,500 7,714 -------- ------------ Total liabilities 395,410 413,476 Shareholders' equity: Preferred stock, no par value; authorized 2,000,000 shares; issued and outstanding 0 and 575,000 shares -- 5,750 Common stock, no par value; authorized 10,000,000 shares; issued and outstanding 3,364,181 and 2,785,261 shares 25,744 19,656 Retained earnings 10,096 8,024 Unrealized loss on investment securities carried as, or transferred from available for sale, net of income taxes (36) (187) -------- ------------ Total shareholders' equity 35,804 33,243 -------- ------------ Total liabilities and shareholders' equity $431,214 $446,719 -------- ------------ -------- ------------ See Notes to Consolidated Financial Statements. This page is page 4 of 24 pages. REDWOOD EMPIRE BANCORP AND SUBSIDIARIES Consolidated Statements of Cash Flows (in thousands) (unaudited) Six Months Ended June 30, 1998 1997 --------- -------- Cash flows from operating activities: Net income $ 2,318 $ 1,464 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization, net 526 330 Net realized gains on securities available for sale (105) 7 Loans originated for sale (220,571) (92,081) Proceeds from sale of loans held for sale 208,900 128,796 Gain on sale of loans and loan servicing (2,602) (2,330) Provision for loan losses 1,020 1,170 Change in other assets and interest receivable 1,522 9,563 Change in other liabilities and interest payable (4,207) (4,901) Noncash restructuring charge -- -- Other, net 430 386 --------- -------- Total adjustments (15,087) 40,940 --------- -------- Net cash (used in) and provided by operating activities (12,769) 42,404 --------- -------- Cash flows from investing activities: Net change in loans 19,980 6,000 Proceeds from sales of loans in portfolio 288 1,973 Purchases of investment securities available for sale (14,079) (7,971) Purchases of investment securities held to maturity (11,131) (730) Sales of investment securities available for sale 2,955 4,020 Maturities of investment securities available for sale 14,900 6,974 Maturities of investment securities held to maturity 11,382 500 Premises and equipment, net (1,020) (540) Purchase of mortgage servicing rights (11) (155) Noninterest bearing demand deposits -- 7 Proceeds from sale of other real estate owned 3,034 846 --------- -------- Net cash provided by investment activities 26,298 10,924 --------- -------- Cash flows from financing activities: Change in noninterest bearing transaction accounts (1,865) 4,468 Change in interest bearing transaction accounts (11,693) (9,050) Change in time deposits (4,294) (44,846) Change in borrowings 4,000 (5,477) Issuance of stock 219 264 Dividends paid (245) (224) --------- -------- Net cash used in financing activities (13,878) (54,865) --------- -------- Net change in cash and cash equivalents (349) (1,537) Cash and cash equivalents at beginning of period 56,058 45,473 --------- -------- Cash and cash equivalents at end of period $ 55,709 $ 43,936 --------- -------- --------- -------- (Continued) This page is page 5 of 24 pages. REDWOOD EMPIRE BANCORP AND SUBSIDIARIES Consolidated Statements of Cash Flows (in thousands) (Continued) Six Months Ended June 30, 1998 1997 --------- -------- Supplemental Disclosures: Cash paid during the period for: Interest expense 5,261 10,581 Noncash investing and financing activities: Transfers from loans to other real estate owned 2,534 2,591 Loans to facilitate sale of other real estate owned -- -- Transfer from mortgage loans held for sale to loans 5,564 1,377 Conversion of Preferred Stock into Common Stock 5,739 -- This page is page 6 of 24 pages. REDWOOD EMPIRE BANCORP AND SUBSIDIARIES Notes to Consolidated Financial Statements (Unaudited) 1. Basis of Presentation The accompanying unaudited consolidated financial statements should be read in conjunction with the financial statements and related notes contained in Redwood Empire Bancorp's 1997 Annual Report to Shareholders. The statements include the accounts of Redwood Empire Bancorp ("Redwood"), and its wholly owned subsidiary, National Bank of the Redwoods ("NBR"). All significant inter-company balances and transactions have been eliminated. The financial information contained in this report reflects all adjustments which, in the opinion of management, are necessary for a fair presentation of the results of the interim periods. All such adjustments are of a normal recurring nature. The results of operations and cash flows for the six months ended June 30, 1998 are not necessarily indicative of the results that may be expected for the year ending December 31, 1998. Certain reclassifications were made to prior period financial statements to conform to current period presentations. For purposes of reporting cash flows, cash and cash equivalents include cash on hand, amounts due from banks, federal funds sold and repurchase agreements. Federal funds sold and repurchase agreements are generally for one day periods. 2. On March 24, 1997, Allied Bank, F.S.B. a wholly owned subsidiary of Redwood, was merged into NBR. In connection with the merger, NBR assumed all of Allied's rights and obligations. As a result of the merger Allied Bank, F.S.B. ceased to exist. 3. Earnings per Share Basic earnings per share excludes dilution and is computed by dividing income available to common shareholders by the weighted-average number of common shares outstanding for the period. Diluted earnings per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the entity. This page is page 7 of 24 pages. Three Months Ended Six Months Ended June 30 June 30 1998 1997 1998 1997 ------ ------ ------ ------ (in thousands except per share amounts) Basic Earnings per share: Net income $1,211 $ 884 $2,318 $1,464 Less: Preferred stock dividend --- 112 112 224 ------ ------ ------ ------ Net income available to common stock shareholders $1,211 $ 772 $2,206 $1,240 ------ ------ ------ ------ ------ ------ ------ ------ Weighted average common shares outstanding 3,141 2,777 2,967 2,766 ------ ------ ------ ------ ------ ------ ------ ------ Basic earnings per share $ 0.39 $ 0.28 $ 0.74 $ 0.45 ------ ------ ------ ------ ------ ------ ------ ------ Diluted Earnings per share: Net income available to common stock shareholders $1,211 $ 772 $2,206 $1,240 Dilutive effect of Preferred Stock dividend -- 112 112 224 ------ ------ ------ ------ $1,211 $ 884 $2,318 $1,464 ------ ------ ------ ------ ------ ------ ------ ------ Weighted average common shares outstanding 3,141 2,777 2,967 2,766 Effect of outstanding stock options 156 88 155 87 Effect of Convertible Preferred Stock 166 499 332 499 ------ ------ ------ ------ 3,463 3,364 3,454 3,352 ------ ------ ------ ------ ------ ------ ------ ------ Diluted earnings per share $ 0.35 $ 0.26 $ 0.67 $ 0.44 ------ ------ ------ ------ ------ ------ ------ ------ 4. Change in Accounting Principles Effective January 1, 1998, the Company adopted Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income". This Statement requires that all items recognized under accounting standards as components of comprehensive earnings be reported in an annual financial statement that is displayed with the same prominence as other annual financial statements. This Statement also requires that an entity classify items of other comprehensive earnings by their nature in an annual financial statement. For example, other comprehensive earnings may include foreign currency translation adjustments, minimum pension liability adjustments, and unrealized gains and losses on marketable securities classified as available-for-sale. Annual financial statements for prior periods will be reclassified, as required. The Company's total comprehensive earnings were as follows: Three Months Ended June 30, Six Months Ended June 30, 1998 1997 1998 1997 --------- ---------- --------- ---------- Net income as reported $1,211 $ 884 $ 2,318 $ 1,464 Other comprehensive income (net of tax): Change in unrealized holding gain (losses) on available for sale securities 132 242 151 (29) Reclassification adjustment -- (4) (25) (5) --------- ---------- --------- ---------- Total comprehensive income $1,343 $ 1,122 $ 2,444 $ 1,430 --------- ---------- --------- ---------- --------- ---------- --------- ---------- This page is page 8 of 24 pages. 5. Preferred Stock Redemption On March 19, 1998 the Company called for redemption of its outstanding 7.8% Noncumulative Convertible Perpetual Preferred Stock, Series A. The redemption notice provided that all shares will be redeemed on April 30, 1998 at $10.39 per share, payable to shareholders of record as of March 27, 1998, who surrender their preferred stock certificates to the conversion agent, Chase Mellon Shareholder Services LLC. The preferred stock was convertible at the option of the holder, into 0.8674 shares of common stock for each share of preferred stock. The total number of shares subject to redemption was reduced by the number of shares of preferred stock converted into common stock between the record date and the redemption date. As a result of the redemption 573,290 shares of the preferred shares were converted into 497,865 shares of common stock effective April 30, 1998. Preferred shares redeemed for cash at $10.39 per share amounted to 1,017. 6. Common Stock Dividend On May 19, 1998 the Board of Directors declared a quarterly cash dividend of 4 cents per share on the Company's Common Stock. The dividend is payable on July 15, 1998 to shareholders of record on June 30, 1998. 7. New Accounting Pronouncement In June, 1998 the Financial Accounting Standards Board issued S.F.A.S. No. 133 "Accounting for Derivative Instruments and Hedging Activities". The statement establishes accounting and reporting standards for derivative instruments and hedging activities. The statement is effective for all fiscal quarters of fiscal years beginning after June 15, 1999. The Company is in the process of determining the impact of S.F.A.S. No. 133 on the Company's financial statements, which is not expected to be material. This page is page 9 of 24 pages. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Redwood Empire Bancorp ("Redwood," and with its subsidiaries the "Company") is a financial institution holding company headquartered in Santa Rosa, California. Redwood has one subsidiary, National Bank of the Redwoods, a national bank ("NBR"). Certain statements in this quarterly report on Form 10-Q include forward-looking information within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and are subject to the "safe harbor" created by those sections. These forward-looking statements involve certain risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements. Such risks and uncertainties include, but are not limited to, the following factors: competitive pressure in the banking industry; changes in the interest rate environment; general economic conditions, either nationally or regionally, are less favorable than expected, resulting in, among other things, a deterioration in credit quality and an increase in the provision for possible loan losses; changes in the regulatory environment; and changes in business conditions, volatility of rate sensitive deposits, operational risks including data processing system failures or fraud; asset/liability matching risks and liquidity risks; and changes in the securities markets. In addition, such risks and uncertainties include mortgage banking activities, merchant card processing and concentration of lending activities all of which have been described in "Certain Important Considerations for Investors". The following sections discuss significant changes and trends in financial condition, capital resources and liquidity of the Company from December 31, 1997 to June 30, 1998, and significant changes and trends in the Company's results of operations for the three and six months ended June 30, 1998, compared to the same period in 1997. SUMMARY OF FINANCIAL RESULTS The Company reported net income of $1,211,000 ($.35 per share, diluted) for the three months ended June 30, 1998, compared to $884,000 ($.26 per share, diluted) for the same period in 1997. Net income for the six months ended June 30, 1998 was $2,318,000 ($.67 per share, diluted) compared to $1,464,000 ($.43 per share, diluted). The increase in net income for the second quarter in 1998 when compared to the same period one year ago is due to a decline of $717,000 in net interest income, an increase of $1,790,000 in non interest income, and an increase of $754,000 in non interest expense. The increase in net income during the first six months of 1998 when compared to the same period in 1997 is due to a decline of $1,232,000 in net interest income, an increase of $2,108,000 in non interest income, and a decrease of $110,000 in non interest expense. This page is page 10 of 24 pages. NET INTEREST INCOME Net interest income decreased $717,000 during the second quarter of 1998 compared to the second quarter of 1997. The decrease is primarily due to a decrease in average earning assets of $20,785,000 or 5%. Net interest margin for the quarter ended June 30, 1998 amounted to 4.90% as compared to 5.37% one year ago. Net interest income of $9,188,000 declined $1,232,000 or 12% for the six months ended June 30, 1998 when compared to the same period one year ago. The decrease is primarily due to a decline in earning assets of $33,653,000 or 8%. Net interest margin for the first six months of 1998 was 4.81% as compared to 5.02% for the same period one year ago. The decline in earning assets during the second quarter is due principally to the decline in average portfolio loans of $58,548,000 being offset by an increase in average investment securities and mortgage loans held for sale of $13,773,000 and $8,689,000. The decline in portfolio loans is attributable to interest rate driven prepayments of mortgage loans, the overall competitive environment, strict credit control and management's desire to balance the components of the Company's loan portfolio. The increase in average investment securities for the quarter compared to the same time period one year ago is a direct result of deploying loan payoff proceeds. The increase in average mortgage loans held for sale for the quarter is attributable to a favorable mortgage interest rate environment. Average earning assets also declined in the first half of 1998 when compared to the same period one year ago. Average earning assets amounted to $381,807,000 during the six month period ended June 30, 1998 as compared to $415,460,000 in 1997. The decline in average earning assets during the first six months of 1998 when compared to 1997 is primarily due to a decline in portfolio loans partially offset by increases in average investment securities and mortgage loans held for sale. The net interest margin for the second quarter declined from 5.37% in 1997 to 4.90% in 1998. Yield on earning assets decreased from 9.55% to 8.74% primarily as a result of payoff of a substantial non accrual loan, including interest, in the second quarter of 1997 and a decline in higher yielding portfolio loans, principally construction loans. As a result of decreased funding needs, the Company significantly reduced its higher cost time certificates of deposits. Average time certificates amounted to $138,409,000 for the second quarter as compared to $174,301,000 one year ago, which results in a decline of $35,892,000 or 21%. This reduction in higher cost liabilities had an effect on overall yield paid for interest-bearing liabilities. Such yield declined to 4.75% from 5.15% in the second quarter of 1998 compared to the same quarter in 1997. The net interest margin for the first six months of 1998 amounted to 4.81% as compared to 5.02% in the same period one year ago. Yield on earning assets declined from 9.26% in 1997 as compared to 8.66% in 1998. Cost of interest bearing liabilities declined from 5.08% in 1997 to 4.83% in 1998. This page is page 11 of 24 pages. The following is an analysis of the net interest margin: Three months ended Three months ended June 30, 1998 June 30, 1997 ------------------------------------- ------------------------------------- Average % Average % (dollars in thousands) Balance Interest Yield Balance Interest Yield ------------------------------------- ------------------------------------- Earning assets (1) $376,513 $8,223 8.74 $397,298 $9,488 9.55 Interest-bearing liabilities 304,101 3,609 4.75 322,977 4,157 5.15 ------- ------- Net interest income $4,614 $5,331 ------- ------- ------- ------- Net interest income to earning assets 4.90 5.37 Six months ended Six months ended June 30, 1998 June 30, 1997 ------------------------------------- ------------------------------------- Average % Average % (dollars in thousands) Balance Interest Yield Balance Interest Yield ------------------------------------- ------------------------------------- Earning assets (1) $381,807 $16,529 8.66 $415,460 $19,226 9.26 Interest-bearing liabilities 303,984 7,342 4.83 346,739 8,806 5.08 ------- ------- Net interest income $ 9,187 $10,420 ------- ------- ------- ------- Net interest income to earning assets 4.81 5.02 (1) Nonaccrual loans are included in the calculation of the average balance of earning assets, and interest not accrued is excluded. The following table sets forth changes in interest income and interest expense for each major category of interest-earning asset and interest-bearing liability, and the amount of change attributable to volume and rate changes for the three and six months ended June 30, 1998 and 1997. Changes not solely attributable to rate or volume have been allocated to rate. Three month periods ending June 30, 1998 over June 30, 1997 -------------------------------------- Volume Rate Total -------------------------------------- (in thousands) Increase (decrease) in interest income: Portfolio loans ($1,687) ($79) ($1,766) Mortgage loans held for sale 264 (79) 185 Investment securities 620 (370) 250 Interest-earning deposits with other institutions (6) -- (6) Federal funds sold 103 (30) 73 -------------------------------------- Total increase (decrease) (706) (558) (1,264) -------------------------------------- Increase (decrease) in interest expense: Interest-bearing transaction accounts (109) (52) (161) Time deposits (280) (147) (427) Other borrowings 179 (138) 41 -------------------------------------- Total increase (decrease) (210) (337) (547) -------------------------------------- Increase in net interest income ($496) ($221) ($717) -------------------------------------- -------------------------------------- This page is page 12 of 24 pages. Year to date June 30, 1998 over June 30, 1997 -------------------------------------- Volume Rate Total -------------------------------------- (in thousands) Increase (decrease) in interest income: Portfolio loans ($3,279) ($179) ($3,458) Mortgage loans held for sale 371 (268) 103 Investment securities 812 (268) 544 Interest-earning deposits with other institutions (6) -- (6) Federal funds sold 169 (48) 121 -------------------------------------- Total increase (decrease) (1,933) (763) (2,696) -------------------------------------- Increase (decrease) in interest expense: Interest-bearing transaction accounts (156) (95) (251) Time deposits (1,040) (204) (1,244) Other borrowings 42 (11) 31 -------------------------------------- Total increase (decrease) (1,154) (310) (1,464) -------------------------------------- Increase in net interest income ($779) ($453) ($1,232) -------------------------------------- -------------------------------------- PROVISION FOR LOAN LOSSES The provision for loan losses for the three months ended June 30, 1998 amounted to $510,000 as compared to $585,000 in the same quarter in the previous year. For the six months ended June 30, 1998, the provision decreased $150,000 from $1,170,000 in 1997 to $1,020,000 in 1998. For further discussion see Allowance for Loan Losses. OTHER OPERATING INCOME AND EXPENSE AND INCOME TAXES Other Operating Income The following table sets forth the components of the Company's other operating income for the six months ended June 30, 1998, as compared to the same period in 1997. Three Months Ended Six Months Ended June 30 June 30 ------------------ % ----------------- % (dollars in thousands) 1998 1997 Change 1998 1997 Change ------ ------ ------ ------ ------ ------ Service charges on deposit accounts 267 285 (6) 541 581 (7) Merchant draft processing, net 605 370 64 1,046 792 32 Loan servicing income 105 199 (47) 284 515 (45) Gain (loss) on securities -- (8) (100) 105 (7) (1,600) Gain on sale of loans and servicing 1,655 823 101 2,602 2,330 12 Mortgage brokerage revenue, net 1,230 479 157 2,314 812 185 Other income 263 187 41 560 321 74 ------ ------ ------ ------ Total other operating income $4,125 $2,335 77 $7,452 $5,344 39 ------ ------ ------ ------ ------ ------ ------ ------ This page is page 13 of 24 pages. Other operating income increased $1,790,000 or 77% to $4,125,000 for the second quarter of 1998 when compared to $2,335,000 for the same period in 1997. Such increase is primarily due to an increase of $832,000 in gain on sale of loans and servicing, an increase of $751,000 in net mortgage loan brokerage revenue, and an increase of $235,000 in merchant card net revenue. Gain on sale revenue is derived from the sale of both sub prime mortgage loans the Company originates and "A" paper mortgage loans originated within the Company's mortgage loan division, Valley Financial. Valley Financial has experienced significant growth in 1998. Net revenue from the mortgage loan brokerage operation amounted to $1,230,000 in the second quarter of 1998 as compared to $479,000 in 1997 and $2,314,000 for the six month period ending June 30, 1998 when compared to $812,000 for the six months ended June 30, 1997. The significant increase in both gain on sale of loans and servicing and mortgage brokerage revenue is due primarily to a favorable interest rate environment and a strong residential purchase market in northern California. Other operating income amounted to $7,452,000 for the six months ended June 30, 1998 as compared to $5,344,000 the same period in 1997. The increase of $2,108,000 is primarily attributable to increases in mortgage loan brokerage revenue, merchant card processing, net revenue, and gain on sale of loans and loan servicing. Other Operating Expense Other operating expense increased by $754,000 or 14% to $6,308,000 during the second quarter of 1998 compared to $5,554,000 for the second quarter of 1997, primarily due to an increase in salary and benefits to accommodate the favorable mortgage loan environment. Other operating expense decreased 1% to $11,957,000 from $12,067,000 for the six months ended June 30, 1998 when compared to the same period in 1997. The following table sets forth the components of the Company's other operating expense during the six months ended June 30, 1998, as compared to the same period in 1997. Three Months Ended Six Months Ended June 30 June 30 ------------------ % ----------------- % (dollars in thousands) 1998 1997 Change 1998 1997 Change ------ ------ ------ ------- ------- ------ Salaries and employee benefits $3,388 $2,500 36 $ 6,391 $ 6,154 4 Occupancy and equipment expense 841 758 11 1,650 1,643 0 Other 2,079 2,296 (9) 3,916 4,270 (8) ------ ------ ------- ------- Total other operating expense $6,308 $5,554 14 $11,957 $12,067 (1) ------ ------ ------- ------- ------ ------ ------- ------- This page is page 14 of 24 pages. INCOME TAXES The Company's effective tax rate varies with changes in the relative amounts of its non-taxable income and nondeductible expenses. The effective rate was 36.96% and 36.72% for the three and six months ended June 30, 1998, compared to 42.0% and 42.1% for the same periods in 1997. The decline in the Company's effective tax rate in the second quarter and first six months of 1998 is due to recording the benefit of certain items arising in previous years. INVESTMENT SECURITIES Total investment securities decreased $3,661,000 or 5% to $68,904,000 as of June 30, 1998 when compared to $72,565,000 as of December 31, 1997. The principal reason for the decline relates to callable agency securities being called by the issuer. Such called securities amounted to $11,900,000 in the first six months of 1998. As a result of this action the Company recorded $70,000 as gain on sale in the first quarter of 1998. MORTGAGE LOANS HELD FOR SALE Mortgage loans held for sale increased $17,463,000 or 103% to $34,392,000 at June 30, 1998 compared to $16,929,000 at December 31, 1997. The increase in mortgage loans held for sale is due to the current low interest rate environment and increased production capability within the Valley Financial unit. In addition to brokering to other financial institutions, Valley Financial also originates loans for sale into the secondary market. LOANS Total loans decreased $26,119,000 or 9% to $256,277,000 at June 30, 1998 compared to $282,396,000 at December 31, 1997. The decline in portfolio loans is attributable to interest rate driven prepayments of mortgage loans, the overall competitive environment for commercial loans, strict credit control, and management's desire to balance the components of the Company's loan portfolio. The Company anticipates that these forces will remain intact for the foreseeable future. This page is page 15 of 24 pages. The following table summarizes the composition of the loan portfolio at June 30, 1998 and December 31, 1997. June 30, 1998 December 31, 1997 ---------------------- ---------------------- (dollars in thousands) Amount % Amount % ---------------------- ---------------------- Residential real estate mortgage $ 90,699 37% $ 93,516 33% Commercial real estate mortgage 57,507 22 57,425 20 Commercial 64,172 25 69,097 24 Real estate construction 39,625 15 55,031 21 Installment and other 6,189 2 9,200 3 Less deferred fees (1,915) (1) (1,873) (1) ---------------------- ---------------------- Total loans 256,277 100% 282,396 100% --- --- --- --- Less allowance for loan losses (7,930) (7,645) -------- -------- Net loans $248,347 $274,751 -------- -------- -------- -------- ALLOWANCE FOR LOAN LOSSES The allowance for loan losses is established through charges to earnings in the form of the provision for loan losses. Loan losses are charged to, and recoveries are credited to, the allowance for loan losses. The provision for loan losses is determined after considering various factors such as loan loss experience, current economic conditions, maturity of the portfolio, size of the portfolio, industry concentrations, borrower credit history, the existing allowance for loan losses, independent loan reviews, current charges and recoveries to the allowance for loan losses, and the overall quality of the portfolio, as determined by management, regulatory agencies, and independent credit review consultants retained by the Company. The adequacy of the Company's allowance for loan losses is based on specific and formula allocations to the Company's loan portfolio. Specific allocations of the allowance for loan losses are made to identified problem or potential problem loans. The specific allocations are increased or decreased through management's reevaluation of the status of the particular problem loans. Loans which do not receive a specific allocation receive an allowance allocation based on a formula, represented by a percentage factor based on underlying collateral, type of loan, historical charge-offs and general economic conditions and other qualitative factors. This page is page 16 of 24 pages. The following table summarizes the Company's allowance for loan losses: Three months ended Six months ended June 30 June 30 ---------------------- ---------------------- (dollars in thousands) 1998 1997 1998 1997 ------ ------ ------ ------ Beginning allowance for loan losses $7,649 $7,085 $7,645 $7,040 Provision for loan losses 510 585 1,020 1,170 Charge-offs (334) (180) (871) (755) Recoveries 105 58 136 93 ------ ------ ------ ------ Ending allowance for loan losses $7,930 $7,548 $7,930 $7,548 ------ ------ ------ ------ ------ ------ ------ ------ Net charge-offs to average loans (annualized) .32% .14% .56% .40% The allowance for loan losses as a percentage of portfolio loans increased from 2.71% at December 31, 1997 to 3.09% at June 30, 1998. The increase in this percentage is due to a $26,119,000 decline in the Company's total loan portfolio. NONPERFORMING ASSETS The following table summarizes the Company's nonperforming assets. June 30, December, 31 (dollars in thousands) 1998 1997 -------- ------------ Nonaccrual loans $ 6,390 $ 7,883 Accruing loans past due 90 days or more 36 735 Restructured loans 1,057 1,109 -------- ------------ Total nonperforming loans 7,483 9,727 Other real estate owned 5,257 6,352 Other assets owned 377 542 -------- ------------ Total nonperforming assets $13,117 $16,621 -------- ------------ -------- ------------ Nonperforming assets to total assets 3.04% 3.72% Nonperforming assets have decreased from $16,621,000 as of December 31, 1997 to $13,117,000 as of June 30, 1998. The principal reasons for this decrease relate to a decrease in nonaccrual loans of $2,244,000, a decrease in other real estate owned of $1,095,000 and a decrease in accruing loans past due 90 days or more of $699,000. This page is page 17 of 24 pages. Nonperforming loans consist of loans to 46 borrowers, 22 of which have balances in excess of $100,000. The two largest have recorded balances of $886,000 and $737,000, both secured by real estate. Based on information currently available, management believes that adequate reserves are included in the allowance for loan losses to cover any loss exposure that may result from these loans. Other real estate owned consists of 30 properties. 19 properties are residential, 7 construction lots and the remaining are undeveloped acres and commercial buildings. Other assets owned included contract receivable rights and repossessed personal property carried at $377,000. Although the volume of nonperforming assets will depend in part on the future economic environment, there are also two loan relationships which total approximately $1,323,000 about which management has serious doubts as to the ability of the borrowers to comply with the present repayment terms and which may become nonperforming assets based on the information presently known about possible credit problems of the borrower. In the first six months of 1998 the Company was required by various mortgage loan investors to repurchase six non performing residential mortgage loans. From time to time the Company may be required to repurchase mortgage loans from investors depending upon representations and warranties of the purchase agreement between the investor and the Company. Such representations and warranties include valid appraisal, status of borrower, first payment default or fraud. Primarily these repurchases involve loans which are in default. The Company expects that it may be required to repurchase loans in the future. The Company maintains a reserve for its estimate of potential losses associated with the potential repurchase of previously sold mortgage loans. Such reserve amounts to $257,000 as of June 30, 1998. At June 30, 1998 the Company's total recorded investment in impaired loans (as defined by SFAS 114 and 118) was $11,788,000 of which $9,558,000 relates to the recorded investment for which there is a related allowance for credit losses of $2,158,000 determined in accordance with these statements and $2,230,000 relates to the amount of that recorded investment for which there is no related allowance for credit losses determined in accordance with these standards. The average recorded investment in the impaired loans during the six months ended June 30, 1998 and June 30, 1997 was $11,888,000 and $17,377,000; the related amount of interest income recognized during the periods that such loans were impaired was $200,000 and $317,000 for the three and six month period ended June 30, 1998 and $534,000 and $520,000 for the same period in 1997. No interest income was recognized using a cash-basis method of accounting during the period that the loans were impaired. This page is page 18 of 24 pages. LIQUIDITY Redwood's primary source of liquidity is dividends from its financial institution subsidiary. Redwood's primary uses of liquidity are associated with cash payments made to the subordinated debt holders, dividend payments made to the preferred stock holders, and operating expenses of the parent. It is Redwood's general policy to retain liquidity at Redwood at a level which management believes to be consistent with the safety and soundness of the Company as a whole. As of June 30, 1998, Redwood held $2,353,000 in deposits at NBR and a $3,000,000 subordinated note issued by NBR. Prior to April 30, 1998 Redwood paid quarterly dividends of 7.8% on its preferred stock of $5,750,000. On April 30, 1998 Redwood converted its preferred stock into common, thus eliminating the preferred dividend. On May 19, 1998 Redwood reinstated its quarterly common dividend at a rate of $.04 per share. Redwood also is required to make monthly payments of interest at 8.5% on $12,000,000 of subordinated debentures issued in 1993. Payment of these obligations is dependent on dividends from NBR. Federal regulatory agencies have the authority to prohibit the payment of dividends by NBR to Redwood if a finding is made that such payment would constitute an unsafe or unsound practice, or if NBR became undercapitalized. If NBR is restricted from paying dividends, Redwood could be unable to pay the above obligations. No assurance can be given as to the ability of NBR to pay dividends to Redwood. During the first six months of 1998, NBR declared dividends of $600,000. Management believes that at June 30, 1998, the Company's liquidity position was adequate for the operations of Redwood and its subsidiary for the foreseeable future. Although each entity within the consolidated Company manages its own liquidity, the Company's consolidated cash flow can be divided into three distinct areas; operating, investing and financing. For the six months ended June 30, 1998 the Company received $12,769,000 and $26,298,000 in cash flows from operating and investing activities while using $13,878,000 in financing activities. CAPITAL RESOURCES A strong capital base is essential to the Company's continued ability to service the needs of its customers. Capital protects depositors and the deposit insurance fund from potential losses and is a source of funds for the substantial investments necessary for the Company to remain competitive. In addition, adequate capital and earnings enable the Company to gain access to the capital markets to supplement its internal growth of capital. Capital is generated internally primarily through earnings retention. The Company and NBR are required to maintain minimum capital ratios defined by various federal government regulatory agencies. The FRB and the OCC have each established capital guidelines, which include minimum capital requirements. The regulations impose three sets of standards: a "risk-based", "leverage" and "tangible" capital standard. This page is page 19 of 24 pages. Under the risk-based capital standard, assets reported on an institution's balance sheet and certain off-balance sheet items are assigned to risk categories, each of which is assigned a risk weight. This standard characterizes an institution's capital as being "Tier 1" capital (defined as principally comprising shareholders' equity and noncumulative preferred stock) and "Tier 2" capital (defined as principally comprising the allowance for loan losses and subordinated debt). Under the leverage capital standard, an institution must maintain a specified minimum ratio of Tier 1 capital to total assets, with the minimum ratio ranging from 4% to 6%. The leverage ratio for the Company and NBR is based on average assets for the quarter. The following table summarizes the consolidated capital ratios and the capital ratios of the principal subsidiaries at December 31, 1997 and June 30, 1998. Company NBR --------------------- June 30, 1998 Total capital to risk based assets 15.76% 14.85% Tier 1 capital to risk based assets 10.75 12.64 Leverage ratio 8.10 9.62 December 31, 1997 Total capital to risk based assets 14.64 13.83 Tier 1 capital to risk based assets 9.72 11.65 Leverage ratio 7.10 8.58 CERTAIN IMPORTANT CONSIDERATIONS FOR INVESTORS MORTGAGE BANKING AND BROKERAGE ACTIVITY. The Company's historic results of operations has been significantly influenced by mortgage banking activity, which can fluctuate significantly, in both volume and profitability, with changes in interest rate movements. In the fourth quarter of 1996, the Company significantly curtailed its "A paper" wholesale mortgage loan production. As a result of this action, the Company's future mortgage loan production revenue and expenses will be significantly reduced from pre 1997 levels. The Company's current mortgage banking operations include both the origination and brokering of retail oriented mortgage loan production. Such mortgage loan lending activity primarily is centered in northern California. The Company's ability to maintain and grow mortgage banking and brokerage revenue depends on a favorable interest rate, economic, and real estate market conditions. This page is page 20 of 24 pages. MERCHANT CREDIT CARD PROCESSING. The Company's profitability can be negatively impacted should one of the Company's merchant credit card customers be unable to pay on charge-backs from cardholders. Due to a contractual obligation between the Company and Visa and Mastercard, NBR stands in the place of the merchant in the event that a merchant is unable to pay on charge-backs from cardholders. Management has taken certain actions to decrease the risk of merchant bankruptcy with its merchant bankcard business. These steps include the discontinuance of high-risk accounts. The Company utilizes independent sales organizations (ISO) to acquire merchant credit card customers. The Company's ability to maintain and grow net revenue from its merchant credit card processing operation is dependent upon maintaining these ISO relationships. CONCENTRATION OF LENDING ACTIVITIES. Concentration of the Company's lending activities in the real estate sector, including construction loans could have the effect of intensifying the impact on the Company of adverse changes in real estate market in the Company's lending areas. At June 30, 1998, approximately 73% of the Company's loans were secured by real estate, of which 31% were secured by commercial real estate, including small office buildings, owner-user office/warehouses, mixed use residential and commercial properties and retail properties. Substantially all of the properties that secure the Company's present loans are located within Northern and Central California. The ability of the Company to continue to originate mortgage or construction loans may be impaired by adverse changes in local or regional economic conditions, adverse changes in the real estate market, increasing interest rates, or acts of nature (including earthquakes, which may cause uninsured damage and other loss of value to real estate that secures the Company's loans). Due to the concentration of the Company's real estate collateral, such events could have a significant adverse impact on the value of such collateral or the Company's earnings. This page is page 21 of 24 pages. PART II. - OTHER INFORMATION ITEM 2. CHANGES IN SECURITIES On March 19, 1998 the Company called for redemption of its outstanding 7.8% Noncumulative Convertible Perpetual Preferred Stock Series A. The redemption notice provided that all shares will be redeemed on April 30, 1998 at $10.39 per share, payable to shareholders of record as of March 27, 1998, who surrender their preferred stock certificates to the conversion agent, Chase Mellon Shareholder Services LLC. The preferred stock is convertible at the option of the holder, into 0.8674 shares of common stock for each share of preferred stock. The total number of shares subject to redemption will be reduced by the number of shares of preferred stock converted into common stock between the record date and the redemption date. As a result of the redemption 573,290 shares of the preferred shares were converted into 497,865 shares of common stock effective April 30, 1998. Preferred shares to be redeemed for cash at $10.39 per share amounted to 1,017. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS (a) The Company held its Annual Meeting of Shareholders on May 19, 1998. (b) Proxies for the Annual Meeting were solicited pursuant to Regulation 14 under the Securities Exchange Act of 1934. There was no solicitation in opposition to management's nominees for directors as listed in the Company's proxy statement for the Annual Meeting, and all such nominees were ELECTED. (c) The vote for the nominated directors was as follows: Broker Nominee For Withheld Abstain Non-Vote - ------- --- -------- ------- -------- Haskell E. Boyett 2,590,801 52,850 None 174,535 Richard I. Colombini 2,590,589 53,062 NONE 174,535 Robert D. Cook 2,595,721 47,930 None 174,535 Dennis E. Kelley 2,636,051 7,600 NONE 174,535 Patrick W. Kilkenny 2,592,051 51,000 None 174,535 William B. Stevenson 2,595,644 48,007 NONE 174,535 Tom D. Whitaker 2,598,651 45,000 None 174,535 This page is page 22 of 24 pages. The vote for ratifying the appointment of Deloitte & Touche LLP as the Company's independent auditors was as follows: For 2,588,171 Against 49,833 Abstain 8,347 Broker Non-Vote 174,987 The vote to amend Section 2 of Article III of the Company's Bylaws was as follows: For 1,538,010 Against 153,276 Abstain 85,220 Broker Non-Vote 1,044,832 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) EXHIBIT 11 Basic earnings per share excludes dilution and is computed by dividing income available to common shareholders by the weighted-average number of common shares outstanding for the period. Diluted earnings per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the entity. See Footnote 3 "Earnings per Share". (b) REPORTS ON FORM 8-K Form 8-K dated April 30, 1998 announcing first quarter 1998 financial results. Form 8-K dated May 12, 1998 announcing the redemption of the 7.8% Noncumulative Convertible Perpetual Preferred Stock, Series A. Form 8-K dated May 20, 1998 announcing the reinstatement of quarterly cash dividends on the Company's Common Stock. This page is page 23 of 24 pages. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized and in the capacity indicated. REDWOOD EMPIRE BANCORP (Registrant) DATE: 08/13/98 BY: /s/ James E. Beckwith -------- --------------------- James E. Beckwith Executive Vice President, Chief Financial Officer, Principal Financial Officer, and Principal Accounting Officer This page is page 24 of 24 pages.